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Book Review

The Four Pillars of Investing: Ch 3, 4

In Chapter 3, “The Market Is Smarter Than You Are” Bernstein lays out the case for the Efficient Market Hypothesis and that stock picking is impossible. He details how its somewhat possible to beat market returns by becoming active in the management of the companies you buy (ala Warren Buffet) or by managing small funds and working hard (ala Peter Lynch). He makes the case that its possible to find mis-priced equities, but that its a lot of work and will only give you a slightly improved return (for most people their efforts would be more lucratively applied elsewhere).

By the end of this chapter Bernstein had me doubting the Derek Foster approach to investing. I believe what Bernstein is debunking is the idea of buying stocks then reselling them a future date based on “superior knowledge” that its under-priced currently and will be over-priced in the future (and that you’ll be able to tell when that occurs). I’m hopeful that buying tax-advantaged income producing stocks (with no intention of selling them) is a different game.

Chapter 4 details asset allocation and how its possible to combine asset classes to decrease volatility and IMPROVE returns. Its a little confusing as he discounts historical records of returns, but then believes historical records of risk (he claims one is valid but the other isn’t and I wasn’t able to follow his reasoning on this point). I posted on this subject previously and he made a good case of convincing me that asset allocation is one of the best places for investors to spend their time / mental energy.

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Personal Finance

Repay HBP or pay down mortgage?

This post is a continuation of Monday’s post which concluded that making an extra rrsp contribution is better than making an extra HBP repayment. Today’s issue is whether it’s better to make an extra HBP repayment or pay down the mortgage.

This one is not as clear cut as the rrsp vs HBP issue. If you put money into the rrsp then you could potentially make a better rate of return compared to the interest on your mortgage, on the other hand, paying down the mortgage gives the guaranteed return of your interest rate.

I would say that for a typical example of someone who owes a lot more on their mortgage than they do on their HBP, the deciding factor is interest rate risk. This is something which I’ve talked about previously and basically it refers to the risk involved if interest rates go up. One great feature of the HBP is that there is no interest rate risk because there is no interest paid. Regardless of what the prime rate is, or mortgage rates are, the amount you owe on the HBP is constant. Your mortgage however, has no such benefit since the interest charged will go up or down with the mortgage rates.

If you have extra money and you make an extra HBP repayment, then your interest rate risk will not change. If you instead make an extra payment to your mortgage, then your interest rate risk will decrease.

Bottom line then is that you should consider making extra mortgage payments and rrsp contributions before paying extra HBP payments. In my case I plan to completely pay off my mortgage and max out my rrsp and only then will I consider making extra payments to the HBP.

Categories
Personal Finance

How To Get Scammed

1) Find “high-return, no-risk” opportunities and give them your money

2) Do business with someone who tells you to “trust me”

3) Do business with someone who discourages you from talking to other people (“this is a confidential matter, don’t tell anyone about it”, “don’t let your friends and family be dream-stealers!”, “don’t talk to a lawyer/banker/accountant, they’ll suck the blood out of you and stop the deal because they’re overly conservative”)

4) Do business with someone who wants to teach you how to make lots of money (by doing a deal with them where you put up your money and they dictate how every element of the deal will work in order to “teach” you)

5) Blindly follow a “secret path to wealth”. Get angry at anyone who questions the path or points out flaws.

6) Pay gurus for “secret” information

7) Pay guru-students for second-hand “secret” information

8 ) Invest in “business opportunities” discovered on lamp posts, in the classifieds, on USENET or in your e-mail inbox.

9) Ignore anything that’s “too complicated” and only pursue simple strategies

10) Believe that its easy to “work smart instead of hard” (and that someone can show you how to “work smart” in a short period of time)

Any other ideas?

Categories
Real Estate

House Bidding Wars

I read yet another article in the newspaper today about a bidding war in Toronto and how this is supposedly a big problem for people who are trying to buy a new house, especially if it’s their first one.

The article covered a house sale sale where they were asking $1.3 million and got $1.9 million which is pretty amazing when you consider they got almost 50% more than they were asking for. Now I don’t know if this house is worth $1.9 million or not but from the description it sure sounds like a pretty good house in a pretty good area.

Later in the article there were some comments from real estate agents who were saying that a lot of their clients are tired of getting into bidding wars and having houses sell for more than asking. They also mentioned how some clients just refuse to rent because they have been taught (brainwashed?) about the value of house ownership by their boomer parents. I think those house buyers should consider the value of renting according to Financial Jungle. Ok, it’s a different city but the logic still applies.

Know your real estate market

When I was looking for my current house, I made an effort to look at as many houses as possible in order to get a sense of the market value for the type of house we wanted. Normally what I would do is look at a house, and then see what it would sell for. After a while I noticed that there were some houses that sold for over asking (bidding war), some houses that sold for around the asking price (quick sales) and some houses that sold for less than the original asking price, in some cases much less (greedy, delusional sellers).

Asking price is meaningless

What did I learn from this? Mainly that the asking price doesn’t mean anything. It’s up the buyer to know roughly what the house is worth by getting familiar with the market. If you look at a house and think it will be a steal for $450k, then guess what…you won’t be alone, since there will probably be other people who will be thinking the same thing. Don’t complain if the house ends up going for $500k or $550k. If that’s what it’s worth then that’s what it will sell for. The other thing for buyers to consider, especially for their first house is that maybe their dream of owning a detached house on a nice street on their limited budget is a fantasy and they should start looking at different areas, semi-detached houses, townhouses and condos and just work with that they have.

Categories
Investing

Why Asset Allocation Works

People keep going on about how important asset allocation is. I left the party when they claimed that a stock & bond mix would perform better over the long-haul then an all stock portfolio. They acknowledged that the stocks would do better on average, but that the mix would somehow magically outperform the all stock.

This didn’t make any sense to me. If you leave two investments for 30 years and get the average stock return on the all-stock portfolio and the average bond return on the all-bond portfolio, how is the return greater if you mix them together instead of keeping them separate?

The only way I thought it could possibly make sense is the idea that you’d have funds available in the bond portion of your portfolio to use to buy stock after a crash. The primary advantage from this perspective would be that the bonds aren’t correlated with the stocks, so you could use one to buy the other. Asset evangelists don’t talk about this though, and since you’d have to actively capitalize on this, it seems like something they’d mention as a necessary step to get the good returns promised by asset allocation.

The realization finally hit me when reading “Four Pillars” this morning: The benefit comes from using the assets within your portfolio to determine when the other parts of your portfolio are cheap, then buying them. E.g. if you have a 90% stock, 10% bond portfolio, you’d expect that the stocks will outperform the bonds. If you’re re-balancing (say by adding money) and your portfolio has 85% stock, then clearly the stocks are selling cheap (relative to your bonds) and its worth buying more of them (which you’ll do to re-balance). When you add money, you’d normally expect to be buying more than 10% bonds (since on average the stocks will outperform the bonds and push them to a lower proportion of your portfolio), but if the stocks REALLY outperform the bonds, then you’ll buy even more then normal (and take advantage of the bonds being cheap relative to the stock).

Basically, asset allocation is just an easy way to determine when the investments you want to buy are cheap (relative to your other investments), then buy more of them. You could accomplish the exact same “benefit” from tracking when your investments are cheap or expensive and buying them directly, however this would be a lot more work. You could also just track the different assets within your portfolio and have the return for the last year and the return for the lifetime of the portfolio. When the last year’s return is lower then the lifetime return you’d put more of the money you’re adding to that portion – again not quite as easy but uses the same idea.

e.g.

Year 1 $90,000 stock, $10,000 bonds
Year 2 $96,300 stock (7% return), $10,300 (3% return)

Say we’re adding $1,000, in order to rebalance the asset allocation, we’d be putting $540 into stocks and $460 into bonds (bringing them back to 90/10).

Year 2 $96,840 stock, $10,760 bonds (after adding $1000 and re balancing)
Year 3 $96,840 stock (0% return), $11,082.8 bonds (3% return)

Say we’re adding $1000 again in order to re balance, in order to get back to the 90/10 split, we need to sell $192.52 of bonds and buy $1,190.52 of stock (we’re buying lots of stock since it had such an awful year that we now feel that its cheap).

Year 3 $98,030.52 stock, $10,892.28 bonds (after adding $1000 and re-balancing).

Part of me feels like “supporting” under-performing bond returns just for the information of when stocks are cheap doesn’t seem like the best approach, but maybe there’s more to it then I’m seeing. I’d be tempted to construct a portfolio and assign it the expected return for each asset class. When an asset doesn’t live up to expections, add money to it to bring it in line with where it “should be”. For example, in the above portfolio with 90% and 10% with an expected stock return of 7% and an expected bond return of 3%, after 10 years you’d expect the stock portion to make up 93.4% of the portfolio. *THIS* is what you’d use to re-balance, not 90%. This way you’d get the information that an asset class was under-performing and have the opportunity to buy it cheap, without unduly subsidizing the weaker portions of your portfolio.

Please correct me if I’ve missed the point. Given my current understanding, I’m far more convinced of the value of asset allocation.

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Personal Finance

Guaranteed Stupidity

I’ve been of the opinion that financial products that guarantee that you won’t “lose” any of your original investment and also offer an upside due to an equity component are not a good deal because of the high fees involved. Jonathan Chevreau covers some of these products today in his blog and article which got me thinking about the fact that financial companies are no different than any other companies in that if there is a market for a product then they will produce that product and try to make as much profit as possible. The reason that it’s possible for them to offer inferior financial products at a profit is simply because of the ignorance of the consumer.

If an investor buys a principal guaranteed product which entitles them to get their original investment back regardless of how the equity portion does, have they really conserved all their capital? In fact if you invest $10,000 today and then sell the investment in 10 years for $10,000 then your investment will be worth only $7374 in today’s dollars at 3% inflation. Inflation is one of the more important aspects of financial planning and cannot be ignored.

That investor would be better far better off to create their own low cost portfolio of at least 40% equity in order to keep up with inflation.

Even if said investor was still willing to ignore inflation and wanted to guarantee their “principal”, what they should do is create their own guaranteed product by buying a combination of GICs and equity (low cost index funds or ETFs). If for example you could buy a 10 year GIC at 4% then the above investor could invest $6755 in the GIC and the remaining $3244 in a couple of equity index funds. After 10 years, the worst case scenario is the equity component is worth $0 and the GICs will be worth $10,000 which will mean that the investor still has his original $10,000. A more likely scenario is that the equities will obtain a return – let’s say 7% which will mean that the equity portion will end up being worth $6382 and the final investment will be worth $16382 which gives the investor a return of 5% which beats the inflation by 2%. Obviously over a 10 year time period the equity returns could vary greatly.

Categories
Personal Finance

The Financial Industry Preys on Inertia

Thicken My Wallet recently made the brilliant statement “The Financial Industry Preys on Inertia”. Tied in with Money Gardener’s Relationship Banking post I think this single statement summarizes a great deal of the problems of banking and personal financial management, and at the same time points out a simple solution.

When a bank offers a teaser rate, what they’re basically saying to you is “you’re so stupid and lazy, we don’t even need to offer you much of a deal. We’ll offer you a good deal for a short time, then milk you for the rest of your life. Ha ha, ha ha, ha ha”. The pathetic part is they’re right – we are stupid and lazy. Apparently bank’s love sending out mortgage renewal forms right before the end of a mortgage term (I’m not sure exactly how this works, I’ve never renewed a mortgage), so that you don’t have time to shop around. Most people sign the form, get the mortgage from the same institution again, and pay a higher rate then what that institution is offering new mortgage applicants!!! If you do this I hate you (as Ramit Sethi would say). Inertia makes the bank money (at your expense).

A buddy of mine is a teacher and didn’t even know what his salary was (he made two guess, $10K apart and said it was “one of those, I think”). I can’t criticize him too much, as I’ve lost checks a few times and discovered that I missed payment (once for around $1500). He didn’t bother contributing to his RRSP, because one of his colleagues had told him “it’s better not to”. I asked him what her reasoning was for such advice and he had no idea (the only thing I can think of is that their pension is so good they can rely on that for retirement planning – I’m not so sure about this myself, but I’m not a teacher). Its great when we work a job we love, and earn enough money that we don’t need to think about it, but we’re stupid and lazy beasts (things might change in the future, why not spend a bit of time planning for it).

We work very hard for our money (in most cases). It blows my mind how willing people are to throw away thousands of dollars (often many, many weeks of labour once you factor in taxes and living expenses) rather than think about something for a couple of minutes or make a 30 minute phone call.

The advantage to this is that if we’re willing to correct our behaviour: to take advantage of the teaser rates then move on to the best deal once its finished, to get pre-approval for a mortgage renewal 120 days before it comes due, and to keep track of our on-going finances, catch money that disappears and plan for retirement, you will be paid handsomely for your time – regardless of what you earn or your lifestyle.

Categories
Personal Finance

Repay Home Buyers Plan or Contribute to RRSP?

I had a discussion last year with my wife where we talked about whether to give our home buyer’s plan debt priority over rrsp contributions.

Although it initially seemed like a good idea to pay the HBP back as soon as possible since it was a smaller amount (about 30k combined), it occurred to me that if you have any rrsp contribution room then you are much better off just paying the minimum HBP repayment amount each year and use any extra money that you want to put into the rrsp for a contribution.

The reason behind this is that whether you are paying back HBP or making an rrsp contribution, the amount that gets added to the rrsp is the same so since the rrsp contribution will give a tax rebate, that is generally the better choice.

For example, let’s say if I have $5000 that I want to put into my rrsp and my minimum annual HBP payment is $1333 and my marginal tax rate is 40%.

If I were to make the minimum HBP payment and contribute the remaining $3667 into my rrsp then my rrsp would have an extra $5000 in it and I would get a tax rebate of $1466.80.

If I were to put the entire $5000 into a HBP repayment then my rrsp would have an extra $5000 in it and I would not get any tax rebate. I would however owe less money to the HBP and future minimum payments will be smaller.

So it’s pretty clear to me that if you have the choice between contributing to your rrsp or extra repayments into your HBP – the rrsp is the winner.